After a reasonable start to the year, rising bond yields, global trade tensions and a strengthening US dollar, among other factors, placed pressure throughout October on equity markets abroad and here at home. In response, many markets including the ASX have given up all their gains for the year with only a couple of months remaining in 2018.
As it stands, we feel the market is in a ‘feeling-out’ period where it is determining whether it’s comfortable with higher yields as a reflection of a strong and robust economy. Or whether higher yields are a sell signal because earnings will be discounted at a higher rate.
When yields rise sharply as they have over the course of 2018, investors essentially reassess how much risk they are willing to take on their investments. In response, what we have seen is evidence of investors reducing their exposure to perceived ‘riskier’ and ‘overvalued’ sectors such as technology.
With the inverse relationship between bond yields and company valuations have being drawn to the forefront of the minds of market participants, investors should understand as bond yields rise, asset prices fall and sometimes by a disproportionate amount depending on a company’s anticipated growth profile. Nevertheless, if company earnings are growing fast enough to offset the negative effects of rising rates, then a company’s valuation shouldn’t necessarily be affected. For instance, if the growth in company profits (which is good for equities) is faster than the rise in interest rates (which is negative for asset prices), then the negative impact of rates is negated.
It’s important in times like these to remember that companies don’t change much, but prices can change a lot. As such, in an attempt to capitalise on the recent market turbulence, we outline 4 high-quality businesses exposed to four different growth sectors of the economy. These businesses in some instances sit more than 20% below their 2018 highs, yet we believe the long-term outlook remains unchanged.
1. Aristocrat Leisure Limited (ASX: ALL)
Sector: Consumer Discretionary
Aristocrat has a portfolio of very highly regarded electronic gaming machines in an industry with significant barriers to entry. It is a leading provider of gaming solutions and manufactures gaming machines to more than 240 gaming jurisdictions around the world. It continues to increase its exposure to the US$138 billion games market, which has grown at double digits rates for over a decade.
Aristocrat has developed over the past 60 years a portfolio of licences to manufacture gaming machines, a broad suite of products, and strong intellectual property. Since 2014, the company has increased the amount of recurring revenue from 24% in 2014, to 65% in 2017. In addition, the US market now accounts for 75% of the company’s earnings and the weakness in the AUD/USD should provide a small boost in the next report.
Of particular interest are the two markets which Aristocrat is targeting going forward as it continues to diversify its business away from gaming machines. The social casino market is estimated at $4.5 billion, and the social gaming market is estimated at $45.9 billion. Both are growing quickly.
Increases in scale are the key to capturing a large portion of these markets, which exhibit high levels of recurring revenue. Meta gaming is behind the recurring revenue as it helps to drive loyalty and user engagement, supported by the interactions around the game itself such as live operations and clubs. These digital businesses have the capacity to drive earnings growth for some time to come.
2. CSL Limited (ASX: CSL)
CSL is one of the world’s largest global plasma providers and manufacturers of influenza vaccines, operating primarily in Australia, the US, Germany, the UK and Switzerland, in addition to having a growing exposure to Asia. Plasma fractionation makes up 85% of CSL’s earnings, with the balance being derived from influenzas vaccines, anti-venom, distribution of pharmaceuticals and royalties from HPV vaccine sales.
To give you a little insight into CSLs business, for every 1 litre of blood plasma only 3-4 grams of the most valuable infection-fighting antibodies, or immunoglobulins, can be extracted. Typically, these can sell for anywhere between $50-$100 a gram, a princely sum for something that there are simply no alternatives. For instance, treatment of haemophilia can cost patients up to $400,000 a year.
It is often alluded to in the financial media that CSL is ‘expensive’, trading on a very high P/E (price earnings) ratio. To some extent that’s true, however we suggest that that’s overly simplistic and ignores a critical point.
Often overlooked when it comes to CSL is the size of its investment in research and development (R&D), which is designed to drive the growth of the future. When it comes to R&D it’s important for investors to consider how this investment is accounted for. At CSL, the costs associated with R&D are conservatively expensed immediately in the year they are incurred. Naturally, this creates a significant lag between when costs are incurred, and when revenues will eventually be received. The impact is essentially to reduce earnings by the amount of the R&D investment, stunting earnings and exaggerating the company’s P/E ratio.
CSL would be well within its rights, like other companies, to expense the R&D investment overtime. This perhaps fairer measure would see the one-year forward P/E of CSL fall from 32x towards a more attractive ~25x earnings.
3. Chorus Limited (ASX: CNU)
Sector: Communication Services
Chorus Limited is the largest telecommunications utility company in New Zealand, owning the copper network and 80% of the new fibre network that is being rolled out across the country. The business is essentially a monopoly operator where wholesale prices are regulated and wholesale broadband pricing increases have been approved up to 2020. The rollout of the fibre network, in partnership with the government, is a key source of growth for the company, with high-quality data increasingly in demand.
The fibre rollout is currently 66% complete with a 45% Ultra-Fast Broadband (UFB) uptake compared with 35% in FY17. The end goal for the company is to achieve 1.05 million premises passed and 1.36 million customers being able to connect by 2022. Management says it is on track to achieve these numbers.
We are confident in Chorus as it is exposed to a clear trend of growing data usage as consumers flock to streaming sites such as Netflix, Pay TV and online gaming that require high-quality content that uses more bandwidth. Investors may also look to the company as an alternative growing dividend source outside of the ASX20, one that has steadily increased dividends over the past 3 years with future cashflow growth likely.
4. Credit Corp Limited (ASX: CCP)
Sector: Financial Services
CCP in our opinion is a high-quality business with a simple business model. The company is the largest player in the Australia and New Zealand debt buying market, with 25% market share and currently holding the largest database of credit impaired customers. The business essentially looks to purchase at a significant discount in the dollar debt between 90 and 180 days in arrears, before looking to collect that debt and make profit on the difference. The real skill for a business such as this comes from identifying value and not paying too much for each new debt ledger purchase.
The recent uptick in guidance for debt ledgers is an important variable, as it allows the collection team to deliver growing cash flows over time. The business exerts high asset turnover and a low cost to collection ratio that has allowed it to increase earnings and dividends each year for the last 10 years. Return on equity has also been trending higher over this period. For a business with an EPS compound annual growth rate (CAGR) of 28%, a P/E ratio at 14.0x seems cheap relative to the market.
The most recent expansion into US debt buying is gaining traction with just under 3% market share, and is on track to deliver 33% of Group revenue and 28% of Group profit for the full year. Conditions in the US remain accommodative as the ability to pay back debt is driven by low and falling unemployment rather than interest rates.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.